Why Australia must keep the carbon price floor

We should not fool ourselves that current international carbon prices reflect efficient climate policy.

Letting Australia's carbon price fall to single digits would destroy incentives to make low-carbon investments, and compound investment uncertainty in the energy sector. It would be extremely short-sighted, and right out of line with the goal of getting the economy on a lower carbon trajectory. The answer for Australia is a carbon price floor.  

The EU carbon permit price, at its current low of around ten dollars per tonne, is not a reflection of the cost of meaningful climate change action. Rather it is an artefact of Europe's economic mess and policy preferences. And the current CDM price of around five dollars per tonne is indeed the price at which these emissions offset credits can be bought in secondary markets, but it bears no resemblance to the actual and expected carbon prices in major trading schemes including the EU, California and South Korea. None of these schemes expect to have their domestic price set in international offset markets.

Europe's economic crisis cuts energy use and thus lowers emissions, but the emissions target remains the same. In addition, many European countries have big subsidies for renewable energy, and impose strict energy efficiency standards. That leaves less to do for the carbon price. Europe may succeed in breathing ambition back into its scheme, but there are no guarantees.

What matters most for Australia though is a glut of credits from developing countries which will be going cheap. Europe has turned its back on the Clean Development Mechanism because of concerns about its environmental credibility, and because it stands in the way of stronger emissions policies in developing countries. The EU has put restrictions on the amount of CDM credits that European emitters can use, and from next year will accept new projects only from least developed countries.

A massive excess supply from CDM projects already underway or in the pipeline is expected. Until 2020, the amount of unsold excess could be several times larger than the total amount that Europe accepts, and far and away higher than Australia's maximum demand.

It is possible to think of scenarios where that overhang in CDM supply gets depleted, for example by a combination of a tighter EU target and relaxation of EU import restrictions, China no longer exporting credits, other countries coming in with additional demand, and perhaps a global fund to buy up excess credits.

But absent some strong developments along these lines, CDM credits could be available to Australian emitters at rock-bottom prices. The price paid for CDM can fall well below the cost of the projects – the bulk of the CDM pipeline was conceived at a time when expectations were for sustained demand at prices much higher than now, and almost all the cost of typical CDM projects is incurred at the start. A gap has already opened between prices for EU permits and CDM credits, which are now traded below five dollars per tonne. All indications are that this gap will open more widely.

Cheap credits are attractive in the short-term, but letting the Australian domestic price fall to something like the five dollar mark would preclude any meaningful domestic action. There would be very little extra incentive to invest in more efficient machinery, or to shift from coal to gas and renewable power.

Yet such investments to lift carbon productivity are the very intent of introducing a carbon price. The longer we dither, the more expensive it will be to cut emissions to a given level down the track, in a growing economy. If the carbon price is of Lilliput proportion, then clean investment will only happen if government steps in with regulation and subsidies. Usually such approaches impose unnecessarily large costs.

The price floor is a good way to deal with the situation. It allows Australia to take advantage of low-cost overseas reductions, while giving greater confidence for investment in low-emissions options. In the recent debate about implementation options for the price floor, there have been claims about residual cost uncertainties for emitters who want to hedge their future liabilities. This should not be confused with uncertainty about carbon prices. Unequivocally, the price floor reduces cost uncertainty for Australian emitters.

The price floor also helps to safeguard revenue for the federal budget. The government's assumption of a $29 carbon price in 2015-16 yielding net receipts of $6.7 billion is wildly unrealistic. Under a $15 price floor, net receipts would be in the order of $3.5 billion. If the price floor was ditched and the Australian price dropped to $5 per tonne, this would leave only around $1.2 billion. But household assistance and some of the payments to industry would not change, so savings would have to be found elsewhere.  

The other way of keeping Australia's domestic carbon price above the artificially depressed CDM price would be an EU-style binding limit on how many credits can be used.

Australia's CDM limit of 50 per cent of total emissions is so high that it will not bind in a free market situation. So in order to achieve reliable incentives for domestic abatement, the limit would need to be lowered. An alternative would be to combine a high limit on use of international credits with a reserve price at auction, in effect achieving a floor price, but without the surrender charge on international units that has been the subject of so much debate by industry.

Looking forward, international carbon markets could remain fragmented for years to come.  For Australia's carbon pricing scheme to work as intended, the best option is to work toward integration with other countries' schemes that have compatible ambition solid price levels – if such schemes exist and if they welcome Australia as a linking partner.

In the meantime, the way to go is to set our carbon price at a level that is in line with longer-term national ambition to cut emissions.

Taking this argument to its logical conclusion implies that the price floor should not be in place for an arbitrary duration such as three years, but until such time as international markets for emissions units reflect the cost of emissions mitigation in key countries, or until Australia's scheme is integrated trading schemes in other schemes that have suitable ambition and stability.

Frank Jotzo is director of the Centre for Climate Economics and Policy at the Australian National University's Crawford School of Public Policy.